Wednesday, July 11, 2012

Inflation for the People

For the past few weeks I've been getting acquainted with the popular wing of the "Austrian economics" movement. First I discovered the Bizarro Economics World of online forums, then I got re-acquainted with Zero Hedge, which seems to have taken a more and more inflationista/goldbuggy/Austrian tone in recent years. Then a bunch of Texan friends started posting "End the Fed!" memes to my Facebook feed. So I went on Facebook and I asked: "Why do people want to end the Fed?" In response, a friend sent me this video:

In the video, a guy loses his house, and his American Dream is crushed. He is then taken back in time by a guy with a horribly fake African-American accent, to witness the source of his problems. As it turns out, everything is the fault of bankers, who steal people's money through fractional reserve banking. Eventually, banking power is concentrated in the hands of a shadowy cabal headed by the Rothschilds, to whom even J.P. Morgan must kowtow. Thomas Jefferson and Andrew Jackson temporarily hold off the evil bankers here in America, ushering in a huge boom "with real money, backed with real gold." But eventually the bankers get in, and end up forming the Fed, which proceeds to steal people's hard-earned money even more via inflation and collaboration with the IRS.

Anyway, for now I'll ignore the oddity of anti-semitic video makers latching onto an economic philosophy (Austrianism) invented by a Jewish guy and a movement (the Ron Paul movement) inspired by another Jewish guy. Anti-semitism has always been a bit weird like that. I'll also put aside the thing about fractional reserve banking (a subject for another post). Instead, I'd like to talk about inflation.

The classic simple example of inflation is this: The Fed (or the banking system, giant Rothschild robots, whatever) doubles the money supply. So money becomes only half as valuable as before. Therefore, the price of everything doubles. So:

Price of a gallon of milk: $4 --> $8

Price of a gallon of gasoline: $4 --> $8

Price of a new house: $200k --> $400k

..and so on. BUT, inflation also doubles your salary, in exactly the same way:

Salary: $40k --> $80k

However, (unless you own a special kind of bond called TIPS), inflation does not change the size of your bank account:

Your savings: $80k --> $80k

So while prices and your salary double, the number of dollars in your savings account stays the same. This makes you poorer, because you can't buy as much stuff with your savings:

So inflation steals your money, right? Well, sure. BUT, wait a second. What if you have a mortgage? Suppose you already bought a house, but you haven't paid off your mortgage yet. You have debt! What happens to this debt when inflation happens? Does it go up? Nope! Just like your bank account, it stays the same:

Your mortgage debt: $160k --> $160k

Now remember, your salary went up when inflation happened. So now, it takes you much less work to pay off your mortgage:

Your mortgage debt: 4 years of your salary --> 2 years of your salary

Inflation stole money from you by shrinking your bank account, but it put money in your pocket by shrinking your mortgage debt!! Notice that the way I have the numbers here, your net worth went up, because your mortgage debt was bigger than your bank account.

So if your net worth goes up and the purchasing power of your income stays the same, as in this simple example, inflation makes you richer. Inflation hurts people who have more savings than debt, and helps people who have more debt than savings.

Who has more savings than debt? Old people and rich people. Who has more debt than savings? Young workers who are paying off mortgages. In other words, the video has it exactly backwards - inflation will not take your house away from you, inflation will prevent your house from being taken away from you. It will save your American Dream. If you don't believe me, go back and look at my example again. It works.

And that hyperinflation that people on Zero Hedge are always screaming about? Well, first of all, it's not coming. But if it did happen, it would mean that your mortgage would be paid up instantly. Really. If our money turned into Monopoly money, you could just pay off your mortgage with a wheelbarrow full of Monopoly money. Perfectly legal!

(Now, you may say "Inflation is still bad, because it punishes saving and rewards reckless borrowing." Well, you're right. That's a danger that the Fed thinks about when they are trying to decide whether to print money in an attempt to boost GDP growth.)

Anyway, what's interesting is that inflation was not always seen as the enemy of the common people. When Thomas Jefferson railed against banks, he worried about deflation as much as inflation. And in the 1800s, the Populist Movement - basically, a bunch of small farmers in the South and West - fought for inflation! At that time, farmers owed a bunch of money to big banks on the East Coast (including J.P. Morgan, who was presumably busy kowtowing to his secret immortal Rothschild masters). Without inflation, they would have to sell their farms to the banks and go be factory workers. So they fought for the United States to go off the gold standard and go on the silver standard - debasing the currency in order to reduce their debts!

Actually, the big banks defeated the Populist farmers. The gold standard was maintained, inflation was prevented, and a lot of people lost their farms. So maybe the robotic Rothschild octopi had the last laugh after all. But they didn't do it through inflation! Quite the opposite. Time was, inflation and currency debasement were seen as the savior of the common man.

Just remember: Inflation hurts people with savings and helps people with debt. An awful lot of Americans these days fall into that second category. Before you go embracing the hard-money, Austrian, gold-standard stuff, think about which category includes you!

(Then again, why should you believe me? After all, I am a Jew. I could be working for...THEM...dum dum dummmmmm...)

118 comments:

Most people with savings have both stocks and bonds. Under current conditions, inflation most likely helps real growth, which helps stocks and, over time, helps bonds (as you reinvest the higher coupon to buy cheaper bonds, you're ahead after the duration of the bonds)

I fully agree. Also, a lot of people have savings in the form of actual physical property, the value of which also depends not so much on the inflation rate, but on a healthy functioning economy (assets like a rental property or small business count as a form of savings).

Plus, as you note, even people with short-term monetary savings (like short-term bonds or anything with a shorter maturity - like a savings account) aren't necessarily hurt that much by inflation. These people always have the option to put their money in physical assets or to seek out a decent interest rate elsewhere. The fact that interest rates today don't necessarily compensate for inflation is the result of the poor economy - real interest rates are negative not because the Fed hasn't cut inflation enough, but rather the result of the Fed trying too hard to keep it down.

The only people who are really screwed by inflation are people who are locked in to long-term, fixed interest monetary instruments. This goes double for people who use short-term debt financing, since even in a world where long-term real rates remain the same, a move to a higher equilibrium level of inflation would lead to higher equilibrium nominal rates.

Of course guess who falls into that last category? The banks - who also just happen to have 5 out of 12 votes, and 12 out of 19 spots, on the government body that sets interest rates. Lucky them.

"a lot of people have savings in the form of actual physical property, the value of which also depends not so much on the inflation rate, but on a healthy functioning economy (assets like a rental property or small business count as a form of savings). "

I'd distinguish between two types of physical property. Those which reduce your real running costs in terms of energy inputs do NOT depend on a healthy functioning economy. Those which are primarily for use by providing services to other people DO depend on a healthy functioning economy.

The explanation you used is simple. The bond/derivatives bubble which a 50% devaluation would wreak havoc on, not so simple. Also wages aren't going up at the same pace as the currency debasement that's been going on already. I read your profile and I'm not surprised to find out you're an academic. They way you guys herd them kids into college and pump that student debt bubble is amazing. But hey it's only bad when ZH pulls off a pump and dump.

This is surprising good -- I was expecting some silliness about numeraires and super-neutrality.

I would only add that the historical story has a final ironic twist. Altho the Populists lost the battle, they did eventually win the war against deflation -- through the creation of the Federal Reserve. The establishment of the Fed was justified in language actually quite similar to the Populists', focusing on the need for an "elastic currency," etc. . So in that sense, the goldbugs and hard-money fetishists are right to the Fed as their enemy. Their mistake is being goldbugs and hard-money fetishists in the first place.

My recollection is that the Populists effectively got what they wanted even earlier. A few years after Bryan's defeat in 1898, the development of the cyanide process and influx of gold from South Africa brought as much inflation as bimetalism would have.

Thank you. I've tried explaining this to people, how leaving the gold standard was of huge political importance around here (I'm in Kansas), and they seem very confused. Honestly, if you think hyperinflation is just around the corner it seems the logical thing to do would be to acquire as many credit cards and banks loans as possible and to max them all out (buy land or gold or whatever, I don't care). I don't see too many people doing this though.

Another excellent post, that I'm sure will fall entirely on deaf ears.

One minor quibble though. Which is that your model seems to assume that savings are not earning a return. That's probably not true, even for old people and rich people. To the extent that they are earning interest or other returns on their savings, those returns will increase with inflation too. So it's ambiguous whether inflation hurts or helps those whose savings are invested in ways that provide variable-rate returns.

So my refinement, which may not be worth it, would be that inflation hurts savers who save in cash or long term fixed-rate investments. It helps everyone else.

I suspect the reason the stock price to inflation relation is not clear is that it is not monotonic. Low to moderate inflation is probably good for equities - though the last decade does not bear that out. High inflation is death to equities - though I don't know where the break point is. Deflation is death to equities too. So maybe too-low inflation is meh! That is consistent with the last decade.

There are myriad reasons why the gold standard is bad economic policy. I don't want to get into that.

One curious thought I always have about goldbugs is how so much of their hate seems to come from simply distrusting the Fed (ie, having zero faith that they'll ward off inflation, maintain the fiat currency, etc.), but once we go on the gold standard, this distrust apparently just magically goes away. The gov't says it has X ounces of gold in Fort Knox? Why doubt that? The Gov't says that no matter what, they'll convert this paper money into gold at this specific rate, OF COURSE they'll honor that!

So much of it seems to me like you're just trading having faith that the government will be trustworthy in one situation vs. having faith that they'll be trustworthy in another, but I don't understand why that "trust" goes from 0 to 100% by simply changing WHAT you're trusting them to do.

I've seen a lot of Austrians talk about moving to some kind of new Free Banking Era where banks make their own money (backed by gold with no fractional reserve system, of course). The market determines how much money there needs to be and we all live happily ever after.

When you say inflation, you mean surprise inflation, right? Because typically, your bank account would more or less keep up with anticipated inflation. Paper money would not, though, since paper money doesn't earn interest.

There's another angle to this, which is that investors are taxed on nominal return, so the higher the inflation rate, the higher the effective tax rate on investment income.

In fact, the empirical evidence that interest rates fully adjust to inflation is pretty clearly negative. Which you can interpret either as some institutional factors that prevent even fully anticipated inflation being incorporated into rates, or as very stick inflation expectations so that even persistent inflation includes an unexpected component.

Either way, Noah's analysis is the correct general case and interest rates fully adjusted to inflation is a practically unimportant special case.

Good post, but we're talking about surprise changes in inflation right? Expected inflation should be reflected in the return on savings and the interest on your mortgage.

But, and I think this is the Austrian's point, its the case that somebody gets to spend the money first, say if you counterfeited a whole bunch of dollars you would get a whole bunch of more stuff and everyone else would reach an equilibrium. That even expected inflation caused by more money gets spent by somebody before prices and wages alter.

I don't really believe in price levels, and I'm surprised Austrians do, but I think that is true under any monetary system. I don't really understand why this results in malinvestment, but I think that is the idea.

Well just on the point of theory--no, there doesn't have to be someone able to spend the money before the economy reaches equilibrium, so that they "get a whole bunch of more stuff." The reason is because of expectations. Think about it this way--if firms expect 5% inflation, then they know that they will have to raise their wages by 5% in order to successfully compete for workers, and that their profit-maximizing output price will now be 5% higher. So they simply include the 5% wage hike in their workers' contracts, and increase outprices at the exact same time. As a result, no one is able to buy more goods before the price goes up. (this is even true if they attempt to take out a loan, since banks will require 5% higher interest)

But as others have noted, various price frictions exist that mean that we actually do generally see the effect you mention--higher inflation is correlated with higher output (and employment) in the short run, through a relationship known as the New Keynesian Phillips curve. Whether this causes "malinvestment" depends on context: if the economy is originally producing the optimal amount of output, then increasing inflation will reduce efficiency, since we would have been better off having saved those resources. But if the economy is in a demand-driven recession, then higher inflation will not cause "malinvestment" since the increase in output will make us better off in the aggregate.

You're sort of right...all of these numbers assume a flat tax (i.e., a flat percentage). To see this, subtract 10% from all the numbers and you'll see that it works. (If you have a progressive tax, like we do, it gets a little more complicated.)

BUT, regarding writing off the lost buying power of savings - no, you don't, but you also don't get taxed on the mortgage debt that vanishes when inflation happens! So the example still works just the same.

Actually you do. Your mortgage debt stays the same but the home value rises and you are taxed on the gain. In this country, you get an exemption for a first sale up to a certain amount but the point is your assets are taxed. The more inflation the larger percentage of the assets that are taxed. That's pretty much the only way that governments tax assets. The larger the inflation rate, the larger the taxes are.

Nope! Remember, companies borrow to invest (or they give up the chance to stick the investment funds in a bank, which is the same thing as borrowing).

So inflation discourages saving but encourages borrowing. The effect on investment depends on which happens faster. And the effect should be temporary, because eventually the two effects should exactly cancel out.

By discouraging savings and encouraging borrowing, it *empowers the financial sector* to extract more money. If you're taxing all their money away with a progressive tax, this probably isn't a problem. If you aren't, does this help you get a metastatized financial sector?

Noah, it's not quite that easy to knock down all of Austrian economics. Think of it like a religious cult that's logic-ed its way into some loony beliefs but has some really smart people coming up with the loopy beliefs. Your off-the-cuff "Well that's stupid, and here's why" is something they've already thought of and responded to. Inflation as theft, for example, really isn't the core of the Austrian argument, although it does play a role. (And they would say in response to your piece that while inflation may involve a net gain for some people, that does not change the fact that it's theft. If young people broke into old people's houses and took their money that wouldn't be okay, would it?)

I don't agree with them, but your physicist's reflex that you can disprove this with a few lines of math is the wrong one here, sadly. (As a fellow physics major, the fact that this is even possible saddens me.) Brad DeLong's approach is a bit more useful: http://delong.typepad.com/sdj/2011/11/fictitious-wealth-and-ludwig-von-mises.html

You're right, and I don't mean this post to knock down all of Austrian economics!

In fact, Austrians' main complaint about inflation was that (they claimed) it causes financial bubbles. If true, that would be a BIG reason to worry about inflation! But that idea doesn't seem to have entered the public consciousness nearly as much as the (much shakier) "inflation is theft" idea. So I just wanted to deal with that one idea.

Inflation does not naturally double your salary, there's no assurance of that (especially since most employers rely on the the government's cooked CPI and are using current conditions to implement very paltry increases, if any). Further, I'd wonder if there's any real world data to support that (well in fact I see that the minimum wage would need to be at $10 to keep up with inflation and that median household income is actually down relative to 30 years ago). This model has always seemed to fall apart to me on that underlying assumption.

What does this mean? If wage inflation isn't all of inflation, wouldn't that mean wages don't keep up with prices?Also, that recent Steve Randy Waldman article you linked points out that workers in poor bargaining positions are hurt by inflation. Why is this never mentioned in these pro-inflation articles and posts? My suspicion is that this includes most workers today, and that inflation now would primarily be used as a soft way to lower wages until they equilibrate with those in developing nations (with our wages dropping a lot more than theirs rise).

There's really no evidence to suggest that wages don't keep up with inflation. Here’s a scatter plot that compares annual changes in inflation-adjusted median household incomes with annual changes in core inflation from 1968 to 2010:

Err ... no, you can't really say that. Joe's scatterplot is one part of a large body of evidence showing that wages generally keep up with inflation. You can nitpick about special cases all you like, but that doesn't change the larger point.

"My suspicion is that this includes most workers today, and that inflation now would primarily be used as a soft way to lower wages until they equilibrate with those in developing nations"

There *is* a disagreement between pro-inflation bloggers about whether something like this would result from higher inflation right now. Some (Noah, evidently, Nick Rowe, Robert Waldmann...) take the standard line that inflation means an equal rise in wages (I think this is correct). Others, though, have explicitly argued that US wages need to come down, and have presented inflation as a way to accomplish this (Matt Yglesias, David Glasner, others).

The fact that they "agree" on more inflation but disagree on its effect on wages is bizarre, and has never to my knowledge been pointed out.

I think you're mixing up the effects of inflation in the general case with the effects of inflation under our specific circumstances.

What Noah argues in this post is that in the general case, wages will rise with inflation ... sometimes wages will outpace inflation, sometimes wages will lag inflation, but in the long run real wages should be neutral to inflation (which is what Joe's scatterplot shows).

When people argue that inflation would allow real wages to fall, they are making a much more specific argument. Evidence suggests that nominal wages are sticky ... people are more resistant to pay cuts than they are to a halt in pay increases. Under our particular circumstances -- with output below potential and nominal interest rates at zero -- increased inflation would allow real wages to fall faster without having to decrease nominal wages. The argument is that a faster adjustment of real wages would lead to a faster recovery. This argument does not contradict the more general case in which wages should be neutral to inflation.

OK, that makes sense. But isn't there some tension between saying, "inflation isn't theft because your wages go up!" and saying, "we need inflation so that real wages will go down to get us out of the depression"? We can qualify the latter by saying that on average, or over time, real wages will keep pace with inflation. But the reason "inflation is theft" resonates with people is that it seems like something that happens to them, personally -- I'm not sure that people will be an happier with losing buying power temporarily (or as outliers).

I agree there's some tension -- but that's because the issue is nuanced. It's hard to put on a bumper sticker. For me anyway, the main point is "inflation will make the economy better right now!". Once you unpack that there are a lot of variables, some of which are in opposition to each other, I agree, but the point is still valid.

All things equal, I think many people would accept a little real wage erosion if it could put the economy on sounder footing. And the large number of people with a significant amount of debt would accept real wage erosion eagerly, since their debt would erode much more quickly than their wages.

Speculation seems to be a main driver in the increase of commodities prices - that has absolutely nothing to do with increased wages and very much bears on inflation (at least it affects a majority of the world's population including a significant portion of the population of the United States).

There's no tension between the two arguments, because *at the moment* what's happening is that wealth is being stolen from the people who are forcibly unemployed. What inflation would do right now, theoretically, would be to lower the real wages of the people currently employed but *also* employ a whole lot more people at those wages... so it would RAISE the wages of the people currently unemployed.

The Austrian view is very common and held by many because it is easy to extrapolate from a household. Seeing the economic system as whole is much more difficult. The reason they want a gold standard is they believe it would offer them a positive risk free return. Why take all that risk in the market when burying it in the backyard can do so well?

In spite of my Zero Hedge connection, and my sympathy for Hayek, I do have some Keynesian sympathies, too. Unfortunately, these are almost entirely concentrated toward the ideas of Steve Keen and Hyman Minsky, who I think give a far better exposition of the problems of inflationism than does the Austrian school.

The largest problem is not theft or even the discouragement of capital formation, no no no (although inflation not only redistributes income from savers to debtors, but from those who get the money first, i.e. banks, to those who get the money second).

The largest problem is credit creation beyond the underlying productive capacity, leading to Minsky moments and deleveraging traps, as producers/consumers try to cut spending to pay down debt, thus leading to contraction.

We are currently in a deleveraging trap. Inflationism is not really succeeding at getting us out; there has been a very small decrease in debt-to-GDP but its still far, far, far above the historical norm, and 4% inflation for 5 years won't fix that. I'm very, very keen on Steve Keen's debt jubilee idea, because it tackles the key challenge of excessive debt (I have a graph up today on my blog that shows debt-to-GDP ratio vs industrial production, it's not pretty).

Like I said, the point of this post is to debunk the "inflation is theft" idea (or, really, to qualify it, not debunk it).

The idea that low interest rates cause bubbles is a different idea. Lots of people have looked at that, but as far as I know the jury is still out.

Debt jubilee is easy to achieve...just mail people checks. They will save the money, and their debt will be reduced. If they spend some of the money, so much the better as long as we're in a recession.

@Aziz: "(although inflation not only redistributes income from savers to debtors, but from those who get the money first, i.e. banks, to those who get the money second)"

The so-called Cantillon effects. I don't understand why, in a world rife with injustices, people are so incensed by this one injustice, but there it is.

So expansionary monetary policy helps bankers too much. Fine, if you think that, let's use Noah's idea of monetary expansion and just mail people checks. Then the Cantillon effects favor the little guy. Or, we could do as our colonial ancestors did, and simply print money to pay our soldiers.

"Fine, if you think that, let's use Noah's idea of monetary expansion and just mail people checks. Then the Cantillon effects favor the little guy. Or, we could do as our colonial ancestors did, and simply print money to pay our soldiers."

This would actually have massively positive benefits. I think there is strong evidence that maldistribution is at the root of *all* of our problems -- including the political ones. If the money is shoved into the bottom of the system, the political power of big money will be diluted

With a career in personal finance, I'm always thinking about inflation hedging.

Keep in mind, Noah, it's far more than TIPS, which right now pay about zero real (or even negative).

A well-diversified stock portfolio is well hedged against inflation risk, as it's real assets and real profits that will rise with inflation.

To diversify further, there's investment real estate, like owning and renting out a home -- but first you should read up on it and learn to do it well, and keep in mind the time and trouble. Again, this is a good hedge for inflation, as the rent you get and price of the home will go up with inflation. And, in part you are paid for doing a job – you get a higher return in compensation for the work, but that's some hedge against unemployment, as you will still have that job, and it can be a nice little job for the retired.

You should only have a relatively small amount of liquidity, convenience money in a bank account.

Of course, understanding personal finance well takes a lot of time and effort, and people are extremely busy and haggard in today's America. So many people will not invest their money well. They may, for example, buy long term bonds at locked in interest rates, a big inflation risk.

Or they may make a different mistake, and put all of their money in gold, the worst major long-term investment in history – see the graph on page 11 of Stocks for the Long Run, 4th edition, by Wharton's Jeremy Siegel. A dollar invested in stocks in 1802 grows to $755,163 – inflation adjusted! – by 2006. For bonds $1,083. Gold? $1.95! after over 200 years! Yes, gold is so magical!

And you can even just have money in a money market fund -- with its very short term assets there's close to zero inflation risk.

It's not necessary that anyone face much risk of inflation.

Those who do either (understandably with how busy people are) don't know much about personal finance, or they're purposely taking the risk in exchange for what they think is an expected return high enough to merit it.

No serious gold investor would buy gold in 1802 and hold it forever. Gold is by definition a countercyclical investment that you buy during periods of market deflation and liquidate at the trough, to re-enter the productive sector. I do think we're still quite a way from the absolute (i.e. gold-denominated) trough in equities. I'd be looking for a 1:1 DJIA:AU ratio as the trough (as it has been at the trough of other Kondratieff cycles)

Hehehe. If there was really a successful model for "how portfolio management" works then we'd all be much richer. Personally, I'd rather follow whatever has worked for past generations than Modern Portfolio Theory or anything derived from Black-Scholes (portfolio insurance, anyone?)

You can't time these things exactly, but there are a few critical indicators that really work quite beautifully. When debt-to-GDP ratio growth greatly exceeds productivity growth that is good sign — that's my definition of a Minsky moment, that an economy is entering a deleveraging trap, and that gold will roughly outperform (there are a few equities that outperformed gold in the past few years, e.g. AAPL, but picking stocks against a cyclical equities downturn is risky as hell).

Let's not throw random words around. Black-Scholes is an option pricing formula. MPT is a theoretical equilibrium model of asset returns developed in the late 50's early 60's. Portfolio management refers to asset allocation decisions to achieve a certain risk/return objective. Linking the three requires a number of steps.

Let’s do a dynamic asset allocation based on your idea.

First, we‘d need to know the exact definition of debt-to-GDP ratio and productivity, and the time period over which their growth is measured. Also which country are we measuring this for? US? Suppose the debt growth is lower than productivity growth in every country but the US, how would this affect (global) gold prices? Have you thought this through? Suppose you use the global market, if so how are we weighting each country?

Once you decide on the timing rule, you have to make sure that you don’t have a look-ahead bias ( a common mistake). Economic data is available in real time with a lag (similar to company annual reports which are published 1-6 months after fiscal year end). Once you have the numbers, plot your lagged debt-to-gdp growth/productivity growth values against 3, 12,36 and 60 month future gold, bond and stock returns. Looking at the chart, if you find anything other than random points, then decide on an allocation rule (e.g. 100% gold if debt growth> productivity growth, standard 60/40 otherwise). Compute the sharpe ratio of the strategy subtracting 1% for slippage. If the number you find is greater than 1, then let’s have a discussion.

Was just giving two particularly egregious examples of tools used in portfolio management that were blindsided by unmodelled variables.

The problem with Sharpe ratios is that E[R-Rf] is not really definable. It's just an estimate. As such, any results will be at at least partly self-reported feedback and tend to severely underestimate tail size.

Nonetheless, the estimated Sharpe ratio on gold has generally been estimated to be fairly high (but I don't trust this, because I don't really trust any estimate of expected return):

http://goldseek.com/news/2008/11-19nb/2.jpg

What really matters is profit, not Sharpe ratios or Jensen's alpha. These are not great tools for asset allocation, yet they are great tools for fund managers to baffle wealthy clients into believing they are experts.

If I was going to come up with some portfolio rule based on my insight that there does seem to be a correlation between debt-to-GDP growth outpacing industrial production and gold spikes, I would probably come up with something more flexible than you suggest. Something like 5% gold allocation for every quarter out of the last twenty when debt-to-GDP growth has outpaced industrial output growth, with the balance going into blue chip industrials. This is obviously not a hard and fast rule, and will obviously not work all the time. It's just a heuristic to tinker with.

“Nonetheless, the estimated Sharpe ratio on gold has generally been estimated to be fairly high (but I don't trust this, because I don't really trust any estimate of expected return):

http://goldseek.com/news/2008/11-19nb/2.jpg”

2000-2008? You take one of the best periods for gold and one of the worst periods for stocks. You have to look at a longer time period, like here http://papers.ssrn.com/sol3/papers.cfm?abstract_id=952289Gold has great volatility and kurtosis with lower returns. It’s only value is as a hedge. The question is what exactly is it hedging and whether there are cheaper alternatives.

“What really matters is profit, not Sharpe ratios or Jensen's alpha. These are not great tools for asset allocation, yet they are great tools for fund managers to baffle wealthy clients into believing they are experts. “

Again, you are confusing concepts. Unless you have a risk-free investment, there is no such thing as profit. There is only expectation of profit subject to risk. If all you cared about is increasing expected profit, you can always increase your leverage which will also increase your risk of losing money. Things like jensens alpha or sharp ratio are primitive but useful measures of trying to measure profit subject to risk.

“If I was going to come up with some portfolio rule based on my insight that there does seem to be a correlation between debt-to-GDP growth outpacing industrial production and gold spikes, I would probably come up with something more flexible than you suggest. Something like 5% gold allocation for every quarter out of the last twenty when debt-to-GDP growth has outpaced industrial output growth, with the balance going into blue chip industrials. “

Why 5%? What if the Minsky moment happens the next quarter? Then blue-chicps may go down by say 50% and lets assume gold doubles. You save about 7.5% , not bad but not much of a hedge especially given the amount of returns you are giving up by investing in gold. Also, are you saying that the Minsky moment can happen in any of the next 20 years? Or that the likelihood increases linearly each year over the next 20 years? On what basis would you make these assumptions? If you actually think through them, these assumptions would have significant implications for how much of a hedge you should have each of the 20 years.

“This is obviously not a hard and fast rule, and will obviously not work all the time. It's just a heuristic to tinker with. “

Here is another heuristic: do the exact opposite. During a downturn productivity will go down and debt levels will go up skewing the growth rate differential to be negative. Risk aversion goes up during the downturns which will reduce stock market multiples, which will increase expected returns. Now I don’ take this story seriously but it’s a possibility. So, I computed the numbers, its very weak but it works. Take the 5 year average quarterly growth rate differential of industrial production and debt/gdp. Then look at the next quarter’s S&P 500 total returns. There is a -10% correlation.

“(The "Aziz Disadvantage Minus Fund" — H/T John Paulson for the name)

But it would have worked damn well during the last two half century.

http://research.stlouisfed.org/fred2/graph/?g=8HQ”

No, it goes the other way. That chart’s a mess, and you should not be looking at levels. Download the numbers, compute growth rates (don’t forget to lag) and compare to future gold returns and s&p 500 returns (make sure it’s total return taking dividends into account).

I did a calc on how my "fund" would have performed (though I admit I have not factored in transaction costs, but gold and S&P are both large liquid markets, so my guess is the costs would be low-ish) the results are pretty reasonable (i.e. better than both gold and the S&P)

Without details, I cannot comment on a random chart, especially one that gets the market returns obviously wrong. My guess is you used price return indeces which does not include distributions. Cumulative over 4 decades your numbers for the market will be off by several factors.

Advice when you are doing backtesting:

Learn the details of the data you are using. Where does it come from? How is it constructed, etc? Learn of any biases in the dataset. Think about timing and information availability and put yourself in the shoes of an investor making real-time decisions. Was the data available to the investor at the time he made the investment decision? Macro economic data is released with a lag: http://www.bea.gov/newsreleases/news_release_sort_national.htm Even if there is strong contemporaneous relationship between gold or stock prices with macro variables, it is useless to an investor trying to make money. Also, macro data is revised, sometimes substantially (like last year). If you use revised numbers, again you would be using information that was not available to an investor making decisions at that time. If you do not lag your data or use point-in-time estimates you will have what is called a look-ahead bias and will be capturing a relationship that is not really there.

In addition to using wrong returns, you probably have a look ahead bias. As I mentioned, when you lag the variables, the relationship is the opposite of what you describe.

I used indexed FRED data. The proportions are correct, but the numbers are wrong, because I was correcting for the way I calculated my returns on my "fund"; I started with 100 in both the S&P and Gold accounts, so I had to double the numbers on the indexed gold and S&P prices. I started from 1968, so the values for both AU and S&P are 200=1968. I don't really think of this as problematic, because the proportions are right, I just checked again.

The main criticism that sticks here is that of data unreliability "in the moment". When dealing with complex data like unemployment, you will relatively frequently get big revisions. So too GDP, to a lesser extent, and industrial production, and there are probably revisions in the data set I got from FRED. I'm not sure to what degree this matters, because I don't know how large the variation is.

The actual effects of excess credit creation/industrial growth seem to materialise with a good deal of lag (quite a lot of the time the better years were foreshadowed by a couple of under performing years because I switched the allocations too early), so doing it in real time with lag may actually be superior to doing it in hindsight.

One more thing — I did experiment somewhat with different allocations. I settled on a standard 5% up, 5% down starting from a 50/50 allocation with one exception — a clear change in momentum after a long time in one direction (for example, I ended up with 100% gold for something like 8 quarters before the 2008 GFC) results in a reset to the 50/50 allocation (for me this happened in 2009). I also considered limits (e.g. at 75/25, 25/75) but found that allowing for higher allocations all the way up to 100/0 better represented the underlying momentum.

No, the proportions are wrong. Whether you start with 100, 200, 1 etc. doesn’t matter. I just looked at FRED. It is indeed a price index. What you want to use is what's called a total return index http://en.wikipedia.org/wiki/Total_return_index )

Right now, your market returns are off by a factor of 5.

"The main criticism that sticks here is that of data unreliability "in the moment""

No, the main criticism is the look-ahead bias because of not lagging the data. This will be more severe than the problems with revisions. I'll try again to explain this. VIX and stock market returns are highly negatively correlated on a daily basis. The contempranous correlation is -80%. But the lagged correlations are close to 0. Suppose you devise a trading strategy that goes long the market when the VIX change is negative. If you take changes in VIX in a given day and also compute returns on that same day, this strategy would have turned $1 in 2000 to $150,000 in 2012. That strategy would have a look-ahead bias. If on the other hand you use yesterdays change in VIX to make your decision to invest today, then strategy would turn your $1 in 2000 to only $1.03 in 2012.

Similarly, during a downturn industrial production will go down, so will the stock market. Even if debt levels do not change GDP will go down increasing debt/gdb. All the variables will be highly correlated. But, unless you have a way of predicting industrial production next quarter, that information is useless to you as an investor.

“The actual effects of excess credit creation/industrial growth seem to materialise with a good deal of lag (quite a lot of the time the better years were foreshadowed by a couple of under performing years because I switched the allocations too early), so doing it in real time with lag may actually be superior to doing it in hindsight.”

No, when you lag, as I mentioned (three times now), the relationship is the other way around. But the relationship is very weak (<10% correlation with future returns).

I did not look at after 1988 period. IF you need mkt data you can find it on Ken French's website (add rf to mktrf to get value-weghted returns).

The contempraneous correlation of industrial production - debt/grp growth rates with stock returns is +30%. If you lag by a quarter it becomes -10%.

As we are both looking at the same data, clearly one of us is wrong. So there is probably not much point to continuing the discussion. Regardless, hopefully this has been a fruitful debate.Good luck with your research. One of these days i will write something on gold as an asset class. Perhaps noah will host it as a guest post?

I am doing it in a very idiotic cavemanish way. I am just starting off with a 50/50 allocation, looking at industrial production growth vs debt/GDP growth and moving the allocation 5% for each quarter where one beats the other, with the exception of changes in momentum from a built up position (>75% of one assets) where I am resetting to a 50/50 allocation. You're doing something more sophisticated.

Common stocks (diversified) historically do a little worse than inflation. Remember to include the bankruptcies!

They do better during periods when fraud is controlled. But if you extend the time serious back before 1930 -- crucial to do -- a large percentage of stocks were frauds, and that eats away your advantage.

Money market funds suffer from not being safe due to inclusion of fraudulent securities. Remember 2008!

This gets us back to fraud being the major problem in the system for investors. And why is fraud so common? Because the fraudsters can get away with it because they've bought the government, particularly the SEC and Attorney Generals. And how can they keep their ownership of the government? Because they have a lot more money than the rest of us.

Which gets us back to the true root problem: distribution of wealth. Most rich people didn't earn their money, they stole it, and they need to have it taken away before they steal again.

"Now, you may say "Inflation is still bad, because it punishes saving and rewards reckless borrowing." Well, you're right."

Again, not necessarily. It punishes saving in fixed income long term assets, but not necessarily in stocks, real estate, money market funds. It doesn't necessarily punish savings, just a certain kind of investing.

Inflation does increase uncertainty in some ways, but on the other hand, a little, like four or five percent, can keep us out of liquidity traps and greatly decrease something a lot worse, recessions and depressions.

In fact, as our savings are predominantly in stocks and real estate, I'd love more inflation, like at least four or five percent. It would pull us out of the liquidity trap, fix balance sheets and get people spending, and as a result be very good for the economy and the real profits of our stocks and the demand for our real estate.

"inflation surprises are bad for the old. Investing in stocks and real estate is a young person's game, is it not?"

most investment advisors recommend equities at 30-40% portfolio allocation well into the 70s, along with a decent amount of TIPS inflation protection (for example, widely followed Morningstar's "moderate" allocation targets 43% equities all the way up to 85, with a more conservative portfolio at 20%, there is a lot of diversification within the equity allocation). "fixed income" includes corporate bonds (even high yield, which is more equity like), see my comment below.

I enjoyed the "spontaneous order" from the beginning of the video. I feel like that was put there purposefully.

Also, Rothbard hung out and made strong influence on many anti-semites during the 1980s erra of paleoconservatism. Though his economics is often weak, he is a fascinating character in the american libertarian movement.

I came across this when the whole Ron Paul newsletter story broke. While there is no direct connection (to my knowledge) other then to Lew Rockwell (who has clear cut anti-semitic writings all over the place), the "paleoconservative movement" was in part the idea to unite conservative groups and people to make a large conservative voting block. Appealing to southern conservatives and others disenfranchised by the then transforming Republican party and the dwindling southern Democrats was their game and hence was born the newsletters and some other organizations. This really didn't work as extensively as originally thought and was abandoned. Only a few decades later did there ideas take root on college campuses and youth voters who were more often socially liberal (interestingly Rothbard tried this approach in the 1960s with little success).

Also, look at sites like lewrockwell.com and mises.org. Looking through lists of contributors there are many people with close connections to what I would call "vanilla" hate groups like the League of the South.

The thing about Rothbard is he was all about spreading his word about economic liberty to anyone who he thought would listen. This led to a very prolific career as a writer, but at the same time made for some interesting pieces depending on who he was writing for.

For the record I am not a libertarian, but reason does a good job of documenting their own movement.

Agreed, Noah Smith. Inflation is not theft. Nevertheless, there's a certain symmetry between inflation and deflation that always gets people riled up to support policies opposing one or the other more than the opposite side.

excellent post. one point, is that in a world of bankruptcy, where debtors can walk away and cancel debt, there are scenarios where debt can help both creditors and debtors simultaneously.

Say you have a 170k mortgage and the property is is worth 100k. it would cost you (in terms of your credit score etc.) to walk away, but you would be better off because you would move into a really cheap rental. The fact that there are costs is the reason you stay current on that 170k mortgage in the first place. The creditors claim is not worth 170k, its worth much less, especially if the debtor is just on the cusp of default), where its worth 90k-100k (foreclosure fees, etc).

Inflation reduces your (the debtors) incentive to default. But it also makes the creditor's position better, increasing the value (by reducing the likelihood of default and severity).

(the curve is parabola: up to a certain extent it helps, beyond which inflation erodes the debt).

So i would amend your statement to say that "Inflation hurts people with cash and helps people with debt and in certain scenarios people whose savings are held in risky assets like equities and risky debt."

Beckworth posted a paper documenting the phenomenon during the depression: when the US went off the gold standard and the price level increased, debt and corporate bonds rose dramatically but treasuries declined.

And when people observe that the stock and bond market is correlated with inflation expectations, this is a well grounded observation i would say (up to a point, then inflation would erode the value of equities and debt once the probability of default declined sufficiently far).

/* the worst major long-term investment in history – see the graph on page 11 of Stocks for the Long Run, 4th edition, by Wharton's Jeremy Siegel. A dollar invested in stocks in 1802 grows to $755,163 – inflation adjusted! – by 2006. For bonds $1,083. Gold? $1.95! after over 200 years! Yes, gold is so magical! */

It is wrong to consider gold as an investment when the people who buy it think of it as an alternative currency. (Examples include prominent investors such as Ray Dalio, Jim Rogers etc.)

So yes, as your data points out -- gold has done an excellent job at retaining purchasing power, which is what it does over a long-term horizon.

Stocks and bonds have given a good return over 200 years, thanks to increase in human productivity and ingenuity: but they have also been crappy on shorter time frames like 20 years or so. If a person's prime working years were in that timeframe when these risk assets had pathetic returns, the person got screwed!. (an example is from early 1960's to early 1980 for stocks).

Don't you think using the same medium (the dollar) both as medium of exchange (which is fractionalized and used to create credit) and store of value creates a conflict of interest between debtors and savers? When there are too many debtors (which is the case in the US today) than savers, then don't you think the monetary system could end up being too one-sided towards the debtors?

Don't you think using the same medium (the dollar) both as medium of exchange (which is fractionalized and used to create credit) and store of value creates a conflict of interest between debtors and savers?

No, there is always a conflict of interest between debtors and savers, since savers are lenders! Money just brings monetary policy into the conflict.

When there are too many debtors (which is the case in the US today) than savers, then don't you think the monetary system could end up being too one-sided towards the debtors?

The best argument against gold as an investment was Warren Buffet's comments this year in his letter to shareholders (of which I'm one happy camper): http://www.berkshirehathaway.com/letters/2011ltr.pdf See in particular pages 18-19. As others have noted, the historical return on equities and other investments has outpaced gold and will continue to do so. There may be some short term gains that one can make in gold markets but I go back to Buffet's money quote (about what the current stock of the world's gold could buy based on current valuation), "...we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buyingbinge)."

Under normal circumstances, I'd say go with the cropland, but global warming means that's a crapshoot.

Since I expect the rule of law to fall apart, I believe in picking a location where you can stay put, with adequate water and food and a solid community, and then investing in your house. Not decorative stuff: energy-efficiency.

Did you know that one of the little-heralded causes of the American Revolution was the Brits' attempt to make the colonies embrace Hard Money? Our patriotic ancestors loved their fiat money and the printing press.

I'm a Texan Protestant -- and I believe you! But also: manufacturing. An overvalued currency (and not a debased currency) is what is closing all the factories down.... again, the inverse of what the hard money people believe.

Good historical point about the Populist Farmers. It;s much nearer the truth that deflation is the enemy of the poor.

I've heard it claimed that there is a different inflation rate for different income groups-that in recent years the inflation rate for the rich has gone up but that the rate for the poor has langusihed.

Not necessarily saying this idea of multiple inflation is right or wrong just this is what I've heard.

Intersting. Who are you taking on next? Climate change deniers? On a selfish note, I'd be integrated in posts on urbanisation/the advantages of large towns. My selfish interest is that I live in the most crowded corner of a crowded island, and thought this was a disadvantage, whereas your posts sugsuggest might be the opposite.

PS why do people vote republican I places where people live far apart, and democrat in places where people live close together (or is that a myth)?

"PS why do people vote republican I places where people live far apart, and democrat in places where people live close together (or is that a myth)?"

It's not clear, but my hypothesis is that in places where people live far apart, it is harder to get accurate information. It is also easier to believe ridiculous claims that people can be "independent" if you don't see the other people you rely on very often.

On a deeper note, the idea that altering the value of money can be equated to stealing is a very old idea that predates Austrian economics, and in attacking Austrians you're also attacking thinkers like Adam Smith, ARJ Turgot, and Richard Cantillon who wrote along similar lines and were reacting to very real circumstances.

In medieval Europe, the sovereign was often the realm's biggest financial actor, controlled the mint, and by corollary set the definition of what constituted the unit of account. Debts were payable in these units. Prior to paying off its debts, the sovereign had a huge incentive to "cry up" the coin - reduce the amount of gold in the unit of account, thereby reducing the real amount the sovereign owed its creditors. On the other hand, when the sovereign was creditor and expecting payment, they had a huge incentive to "cry down" the coin, thereby increasing the amount of gold in the unit of account and increasing the real value of what they were to receive.

In short, there have been situations in which inflation and deflation "steal" the public's resources (the public being anyone who is not the sovereign). I would be hesitant to apply this to the modern western situation, but in analyzing the economics of modern third world dictatorships, it is important to understand how the dictator - much like a medieval king - might utilize the monetary system to redistribute resources from the public to his/her circle of cronies and thereby maintain a grip on power. I would strongly recommend most people from these sorts of nations to ignore your somewhat facile and euro-centric description of the effects of inflation and other forms of monetary confiscation, but I doubt they need my advice as they are probably more well-versed in the specifics than I.

Inflation is a reasonable response to over leverage that was generated by the Shadow Banking system. The unregulated Shadow Banks generated more claims on future goods and services than will exist given the current GDP, current GDP growth and current rate of inflation. Some combination of GDP growth and inflation must occur to pay those claims. Those claims generated by the Shadow Banks could have been declared null and void, but instead we bailed out the banks and largely left the claims intact for the very wealthy. Over $4 Trillion in wealth (claims on future goods and services) have been lost by the middle class during the housing bubble collapse and additional $Trillions in income have been lost to high unemployment/ slack demand. That wealth and income has been redistributed upward to the wealthy elite 0.1 percent.

Failure to rapidly return to faster growth and low unemployment makes the long term economy worse. The transfer of huge amounts of wealth to the wealthy elites based on the way the bailout was implemented has left our economy unbalanced. The economy needs to be rebalanced by transferring wealth and income back to those at the middle and bottom of the economy. This means some combination of wage inflation, taxation used to purchase and provide public goods and services and direct transfers such as loan forgiveness programs. The politics, especially the death grip that our wealthy elites have on our economic policy, makes fixing our economy difficult.

Maybe you might want to consider trying to get into "real" Austrian Economics, not just the (currently) popular kind that attracts all these conspiracy nutters. :-)

You'll find much more serious information at the different Mises institutes, they're popping up pretty much in every country. USA's is at mises.org, there are a few others in Latin America and Western/Eastern Europe.

Noah while I agree that Austrian logic is hilariously bad I do think that your simplified example overstates your case. While it is true that inflation as opposed to a shift in relative prices requires wage inflation it only requires wage inflation in the aggregate. It says nothing about the distribution of the increases in nominal income. One of the critiques of traditional monetary policy that I think has some merit is that monetary policy via asset purchases would on its face appear to increase the nominal income of existing asset holders who are more likely to be creditors than debtors. Thus you could envision a scenario where inflation does not improve the situation of debtors and could even theoretically make it worse if their income does not increase while other prices do.

Now I am not saying I am against monetary expansion (I think at this point it is a risk worth taking) and I think Austrians are insane, but I think there are legitimate critiques to the inflation automatically leads to the balance sheet repair that will spur a recovery.

Well, I think that one of the common concerns regarding inflation is the fact that our current high unemployment means that a lot of employers have more leway in how much they pay their workers and that inflation in this job market will NOT translate into wage increases for people. I know that (prior to my lay-off) I watched the prices of groceries skyrocket, while I was "lucky" enough to get an increase of about 0.5% per annum. This, rather than any economic theory about how inflation "should work," is what drives my nervousness about inflation.

>Inflation stole money from you by shrinking your bank account, but it put money in your pocket by shrinking your mortgage debt!!

Do inflation expectations increase the price that houses are sold at, making it more difficult for prospective house buyers to afford what they cost?

The answer is yes, and is part of why China's house prices are so high. And people don't always get wage increases in line with inflation; in fact, some economists support inflation specifically because it allows wage decreases without worrying about nominal downward wage rigidity.

Most people would prefer to be able to have a stable store of value than for house prices to rise for prospective buyers in anticipation of inflation (which might just end up being another price bubble).

The solution to unemployment, without inflation: http://jobcreationplan.blogspot.com/

>inflation will not take your house away from you, inflation will prevent your house from being taken away from you. It will save your American Dream. If you don't believe me, go back and look at my example again. It works.

is only true people with fixed-rate mortgages, which do tend to be common in the US (?). But people pay a premium for this lower risk, and rich people are not likely to be holding onto a lot of cash anyone — that would be poor people — so it doesn't seem very ethical to say that the elderly should be sacrificed so people with existing fixed rate-mortgages can benefit at the expense of everyone else.

This is avoiding the jobs issue anyway. While inflation might slightly increase the discretionary income of people with existing mortgages, people entering the housing market will be locked into higher interest rates and it is difficult to say that it would have any strong positive effect on the economy. The primary mechanism that 'inflation' leads to growth is by forcing people to invest in financial markets at a loss, leading to profits and increased spending by the financial sector.

Inflation does not increase people's salaries at the same time it increases prices. Inflation always enters the market at distinct points, for example Wall Street banks, and THEN it is spent from person to person.

Those who are on relatively fixed incomes, like wage paying jobs and pensions, they experience inflation predominantly as a greater increase in the prices they pay relative to the increase in their incomes.

It is to this extent that inflation hurts poor people. Poor people are almost always last in line in the inflation money flow from person to person.

Inflation could help the poor if the poor were the "primary dealers", and they sold various things to the Fed in exchange for newly created money. But then, of course, the poor would gain at the expense of the rich, would have to pay higher prices before their incomes rise by virtue of the inflation being spent and respent.

One of the major mistakes made in the area of inflation is assuming it increases everyone's bank accounts at the same time, to the same extent.

"It goes like this: even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts."

"Who has more savings than debt? Old people and rich people. Who has more debt than savings? Young workers who are paying off mortgages."

This is totally wrong.

Rich people carry a lot of debt, but it's indirect and via investments. Every time a rich person does a margin trade, a leveraged investment, most ETFs, hedge fund trades, currency trading (leveraged up to 10x or more), those are all debt-based instruments. I guarantee you that if inflation 'helps people with debt' more, then it helps the rich, far, far more than it helps the poor.

The Jefferson quote you linked to explicitly says that his quote about deflation is "at least partly spurious." Furthermore, it points out that the term "deflation" was not even documented until after Jefferson's lifetime.